Bullish Energy Sector Studies Stoke Oil Market

by Joseph Dancy, LSGI Advisors, Inc. | April 7, 2010

A number of reports on the energy sector were released last month. Most of the studies identified trends which are very bullish for long term investors in the energy sector:

International Energy Agency Reports - Emerging markets are driving unexpectedly strong growth of world oil demand this year with a big boost from China, the International Energy Agency noted in a report issued last month. The IEA noted that demand for oil, a strong indicator of economic activity, would not recover in advanced economies this year. But the report noted an "astonishing" growth trend of 28 percent in China. The IEA raised its forecast for global crude oil demand in 2010 to 86.6 million barrels per day from its projection last month of 86.5 million barrels per day -- a 1.8-percent increase from 2009 demand levels.

Demand in the Organization for Economic Cooperation and Development (OECD) areas remains "persistently weak" and the IEA projects it will fall by 0.3 percent this year. The OECD includes 30 developed economies including Britain, France, Germany, Japan and the United States. These countries account for the major part of global economic output.

The IEA is also worried about underinvestment for the exploration and development of crude oil reserves. Global capital spending on those activities, including spending on maintaining or increasing production from existing fields, fell $90 billion, or 19%, in 2009. That decline was the first in a decade. Three trends make this decline particularly troubling to the IEA according to financial columnist Jim Jubak:

First, Western oil companies are increasingly excluded from the most promising areas for exploration and development. National oil companies control access to many of the attractive basins. It is estimated that 85% of oil reserves are controlled by national oil companies. Governments don’t have the same incentives to develop some of these fields as a private firm may have.

Second, as fields are found in more challenging environments the cost of finding oil continues to rise. Western oil majors have recently reported a rise in the drilling failure rate and in the cost of drilling and completion.

Third, the IEA estimates that output from existing fields will drop by almost two-thirds by 2030 due to resource depletion. Decline rates range from 5-8% per year on average, but some fields decline much slower and some much higher.

In the face of these developments the head of the IEA warned that countries must brace for a return of wild price swings in the energy markets as the global economy recovers. The IEA official noted "the cheap energy age is over, and we have to prepare for that in the government and private sector."

"The market could easily become again more volatile once the world economy grows again and the supply tightens" according to IEA officials. They urged governments to open access to energy reserves, noting "encouraging investment on the production side could lessen volatility."

On a similar theme the Bank of America and Barclays Capital, two major oil traders, told clients to brace for crude above $100 a barrel by next year before it pushes higher over the decade. This would be in stark

contrast from recessions in the 1980s and 1990s, when it took years to work off excess production capacity built in the boom.

"The groundwork for the next sustained step up in oil prices is now almost complete. Global spare capacity is likely to be reduced to low levels within a relatively short time. The global economic crisis has postponed, but not cancelled, a crunch which would otherwise be starting to bite now," said Barclays.

NYU World Crude Oil Demand Study - Official forecasts by the Department of Energy, International Energy Agency, and OPEC may be substantially underestimating the future demand for crude oil according to a research paper released last month by Professors Joyce Dargay of the University of Leeds and Dermot Gately of New York University.

Dargay and Gately base their forecast on the fact the global demand for crude oil is no longer as responsive to price as it has been historically. Major price increases seen in the 1970’s significantly reduced worldwide demand for fuel, while the hefty oil price hikes we’ve witnessed over the past decade have had little effect.

The most recent price increases – which saw the price of crude oil rise above $140 (U.S.) a barrel in 2008 – have been met with a relative shrug from consumers. Per capita demand for oil fell just 3 per cent in developed countries, and it actually rose by 4 per cent worldwide.

The professors say the significant reduction in demand in the 1970’s was the result of countries taking advantage of simple conservation measures and economies such as moving away from using crude oil to generate electric power. They caution that those successes in reducing demand most likely won’t be repeated. Specifically they note the transportation sector is very inelastic to crude oil prices, especially in developing countries.

Such rapid growth in demand is unlikely to be met by growth in the supply of conventional oil resources according to the study. Hence they predict the imbalance will most likely be addressed by some combination of (1) higher real oil prices, (2) much more rapid and aggressive penetration of alternative technologies for producing liquids, (3) much stricter conservation policies and standards adopted by multiple countries, or (4) slower world economic growth.

If demand does not moderate in the face of higher prices as the study projects, commentary on the paper notes the ‘next oil crisis is going to be a whopper.’

Kuwait University Crude Oil Supply Report - Last month researchers at Kuwait University’s College of Engineering and Petroleum published a study on global conventional crude oil production. They predicted that global conventional crude oil production will reach maximum levels in 2014 – years earlier than many experts and governments expected.

The research team examined oil production trends in 47 major oil-producing countries which supply most of the world's crude oil. They determined some of the major producing countries have already hit their peak. Canada, the U.S., Mexico, Russia, Norway, the U.K., China, Iran, and Indonesia have all reached peak conventional crude oil production according to the researchers' data. Production is now declining in these countries.

Many countries are expected to see their crude oil production peak after 2014, most notably many OPEC member countries, It was noteworthy that the study found the world's oil reserves are being depleted at a rate of 2.1 percent per year.

While production may be peaking in the next few years if the study is correct, China’s crude oil demand is set to grow by 900,000 barrels a day in the next two years. Chinese oil consumption reached 8.5 million barrels a day last year, compared with 4.8 million in 2000. The country will account for a third of the world’s total consumption growth in 2010.

While China is by far the fastest-growing oil market in the world, the United States is still the top consumer. Despite the slump, Americans consumed 18.5 million barrels a day in 2009. That amounts to 22 barrels of oil a year for each American, compared with 2.4 barrels for each Chinese citizen.

If global conventional crude oil production gains are limited, or reach peak production levels, the study concludes that in the near future unconventional crude oil sources, alternatives, and conservation may be required to meet demand and maintain economic growth. The supply and demand trends identified in the study, if correct, point to much higher crude oil prices in the near future.

The Foundation for the Economics of Sustainability Report – Last month the Foundation for the Economics of Sustainability released a report on the potential impact of a declining global energy supply on the economy, environment, trade, and government. The study concluded that declining global energy flows would reduce economic activity, global trade, impair credit, interfere with the repayment of debt, disrupt critical infrastructure, and interfere with global food supplies.

Fossil fuel energy production is to some extent interchangeable, and we have plenty of coal and apparently natural gas, so a short term concern about declining global energy flows in our opinion is overblown. None-the-less, the study was an interesting analysis of the link between the economy and energy flows.

AccuWeather Summer Hurricane Forecast – AccuWeather issued their 2010 hurricane forecast last month. The firm foresees an active storm season this summer. They forecast 16 to 18 named hurricanes/tropical storms forming in the Atlantic Ocean. Five will become hurricanes, and two or three of them going ashore in the U.S. as major systems. The hurricane season runs from July 1st to November 1st.

We have an interest in the forecast because the Gulf of Mexico is home to about 27 percent of U.S. oil and 15 percent of U.S. natural gas production according to the Department of Energy. And roughly one-third of the nation’s refining capacity is located on the Gulf coast.

Only nine named storms formed during the 2009 season, the fewest in 12 years. Last year was the first time since 2006 that no hurricane hit the U.S. mainland. In 2008, there were 16 named storms, and eight of them were hurricanes. The historical average is for 11 named storms, with six of them becoming hurricanes.

Long Term Energy Trends Identified in U.S. Joint Forces Command Report iamge - The United States Joint Forces Command issued their 2010 Joint Operating Environment report last month. The report examines long term global trends that the U.S. military may be forced to address in the future. The study is also used to formulate strategies and responses that might be effective in dealing with potential adversaries, and to identify resources that may be necessary to prevail in such conflicts.

The Joint Operating Environment report forecasts a world in which energy resources could become insufficient to meet demand. The report notes that by 2012 excess global crude oil productive capacity may disappear, which could result in wildly volatile (and higher) crude oil prices. They note:

A severe energy crunch is inevitable without a massive expansion of production and refining capacity. While it is difficult to predict precisely what economic, political, and strategic effects such a shortfall might produce, it surely would reduce the prospects for growth in both the developing and developed worlds.

Such an economic slowdown would exacerbate other unresolved tensions, push fragile and failing states further down the path toward collapse, and perhaps have serious economic impact on both China and India. At best, it would lead to periods of harsh economic adjustment.

To what extent conservation measures, investments in alternative energy production, and efforts to expand petroleum production from tar sands and shale would mitigate such a period of adjustment is difficult to predict. One should not forget that the Great Depression spawned a number of totalitarian regimes that sought economic prosperity for their nations by ruthless conquest.

The report also notes the explosive economic growth in developing countries and China, and the increasing global demand for reliable supplies of energy:

Absent a major increase in the relative reliance on alternative energy sources . . . oil and coal will continue to drive the energy train. . . That production bottleneck apart, potential sources of future energy supplies nearly all present their own difficulties and vulnerabilities. None of these provide much reason for optimism.

At present the United States possesses approximately 250 million cars, while China with its immensely larger population possesses only 40 million. . . The implications for future conflict are ominous if energy supplies cannot keep up with demand. . .

Conclusion - We agree with most of the studies and reports last month that focused on the energy sector. Most were very bullish for investors in the sector. If the assessments of the long term trends in supply and demand are correct firms in the energy sector in politically stable areas could generate surprisingly robust returns for investors.

Contact Information

Joseph Dancy, Adjunct Professor, Oil & Gas Law, SMU School of Law, Advisor, LSGI Market Letter | Joseph Dancy's Book Reviews | E-mail